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27 February 2013
In a leveraged buy-out the acquisition is typically financed with debt collateralised (directly or indirectly) by the target's own assets. The acquisition may also be directly sponsored by the target.
Leveraged buy-outs experienced explosive growth in the late 1980s – boosted by the high returns realised from the first such transactions in the 1970s and early 1980s – but subsequently declined in the early 1990s. More recently, they have once again been on the rise, but with notable differences that reflect the evolving socioeconomic and regulatory context. Today's leveraged buy-outs involve less leveraged capital structures, are subject to more intense competition and result in lower returns.
This notwithstanding, leveraged buy-outs – especially management buy-outs – are usually an efficient way to enhance the performance of target companies and have a significant effect on working practices. Leveraged buy-outs allow for the application of financial, governance and operational engineering to targets, thus improving operations and generating value.
In order to undertake a leveraged buy-out, the buyer typically incorporates a new company (newco) that allows it to acquire the target's shares – assuming the form of a special purpose vehicle – and provides for both operational and tax efficiency. The target merges with or becomes a subsidiary of the newco. In cross-border transactions, a leveraged buy-out may be conducted through multiple newcos to achieve an optimal tax structure.
Leveraged buy-outs are also often a component of corporate restructurings conducted by specialised leveraged buy-out funds or alternative investment management companies, which engage in a short-term strategic plan often aimed at divesting non-core businesses and rationalising operations.
The guaranteeing or financing of an acquisition by the target is highly restricted under the Portuguese provisions on financial assistance.
The provision of guarantees by companies to other entities is equally forbidden as a rule, since this is considered to fall outside the scope of the company's corporate object. An exception will be made for the granting of guarantees between parent companies and their subsidiaries, provided that they are in a controlling or group relationship, or such action is considered to be in the specific self-interest of the granting company.
Furthermore, Portugal has not transposed EU Directive 2006/68/EC into national law, given that no such obligation was imposed on EU member states. Implementation of the directive would allow companies to enter into financial assistance transactions that would otherwise be prohibited, provided that certain conditions were fulfilled.
Thus, the prohibition applies to any type of transaction between the target and the beneficiary of the financial assistance where it imposes a financial liability upon the target.
The financial assistance prohibition is based on the idea that if a company bears the costs of the purchase of its own shares, this leads to the impoverishment of shareholders. In some jurisdictions, 'whitewash' procedures are in place that allow companies to engage in operations that would otherwise be prohibited under financial assistance rules. Often, shareholders can authorise transactions that would otherwise be void.(1) There is a considerable degree of flexibility across the European Union, with other member states allowing financial assistance up to the limit of the company's reserves. Portugal has adopted a strict approach under which no whitewash procedures are available, even if the granting of financial assistance would not necessarily result in a reduction of the company's assets. Financial assistance or shareholding acquisitions in breach of the rules mentioned above will be deemed null and void, and members of the target's board of directors may incur civil and criminal liability for granting financial assistance to a buyer.
As a result, joint stock companies are prohibited from issuing loans, granting capital or providing guarantees for the purpose of a third party underwriting or in any form acquiring their own shares. This ban is intended to protect creditors and minority shareholders from potential misuse of the company's assets in order to collateralise an acquisition, as well as to prevent manipulation of the underlying securities' market price and curb abusive practices during takeovers. Nonetheless, the following exceptions are permitted:
In addition to the financial assistance provisions, the rules on own share ownership and the application of the business judgement rule need to be considered when deciding whether to proceed with a leveraged buy-out. As a rule, self-ownership by companies in Portugal is prohibited or limited, given that they cannot acquire and hold shares representing more than 10% of their capital. Shares in excess of this threshold may be acquired only if:
Where leveraged buy-outs are concerned, self-ownership may take place in conjunction with the granting of financial assistance.
Although the rules on own shares and financial assistance are not aimed at preventing the same hazards, the issue of guarantees by a subsidiary to a third party in relation to a loan granted to a parent company generally breaches the underlying reasoning of both the financial assistance and own shares provisions (ie, to prevent a company from bearing the costs of the acquisition).
Furthermore, directors should consider whether any transaction, including those involving financial assistance, is – if not in breach of mandatory provisions – consistent with their duty to act in good faith and in the best interests of the company, and whether it is likely to improve the company's performance for the benefit of shareholders.
The prohibition on financial applies only to joint stock companies, as private limited companies are not contemplated by the rule.
Leveraged buy-outs have been the subject of intense debate over the past few decades. European M&A experts have highlighted that a prohibition on financial assistance is redundant or unnecessary (and non-existent in some jurisdictions, such as the United States). It could even be considered harmful, since it may obstruct legitimate and economically worthwhile transactions. Furthermore, companies can handle higher leverage levels if access is granted to the equity capital of a leveraged buy-out fund, which in turn may allow for easier debt restructuring if required.
EU Directive 2006/68/EC has demonstrated the European Union's intention to relax the financial assistance prohibition, although with little success. Moreover, some scholars have noted that even though leveraged buy-outs are highly restricted by the legal frameworks of European countries, they are performed nevertheless.
Bearing this in mind, a leveraged buy-out may be structured in such way that there is no direct assistance from the target, thus avoiding the general prohibition rule. As a result, some experts make a distinction between simple leveraged buy-outs and merger leveraged buy-outs. A Spanish court has even considered merger leveraged buy-outs not to be covered by the financial assistance prohibition.
In such leveraged buy-out structures, the target's lenders and minority shareholders seem to be protected by the guarantees provided by the merger process, which apparently provide legal grounds for some of these leveraged buy-outs. The acquisition is generally financed by private equity funds – not directly by the target – and security is granted after the merger takes place.
Nonetheless, downstream mergers may not be the best option. Given that in this case the newco or the purchaser itself is incorporated into the target, the transaction may involve the acquisition of own shares upon the merger and trigger financial prohibition rules or specific provisions on the acquisition of own shares, since the debt raised to finance the leveraged buy-out will be directly (or indirectly) reimbursed by the target. The success of a downstream merger may also be contingent on the absence of a specific clause in the target's articles of association forbidding or limiting the acquisition of own shares.
Conversely, in an upstream merger leveraged buy-out, reimbursement of debt and its security are formally provided by the newco after the merger, given that the target is merged with it and ceases to exist. In this case, the target may have no intervention in the deal, except as the object of it, and these circumstances may therefore be deemed outside the rules governing financial assistance. This notwithstanding, the legality of a merger leveraged buy-out is uncertain, given the thin line separating it from other leveraged buy-outs. This matter is the subject of much debate.
Although the issue has never been tested in Portugal's courts to date, the stringent rules on financial assistance, guarantees and own shares mean that minority shareholders, lenders or any other interested parties could argue that a transaction structured as a merger leveraged buy-out violates such rules and could thus challenge the transaction in court. Regardless of the decision in such a case, the outcome would undoubtedly be ground breaking.
Directive 2006/68/EC has shown the European Union's intention to relax the financial assistance prohibition, which would allow companies and markets to increase their competitiveness. Nevertheless, Portugal has not incorporated the directive into national law or adopted any whitewash procedures. Thus, leveraged buy-outs are still highly restricted under Portuguese law, given the general prohibition on financial assistance by the target through the granting of a loan to the buyer or security for a third-party loan to a buyer. However, the prohibition applies only to joint stock companies and not to private limited companies. Furthermore, but not beyond doubt, an upstream merger leveraged buy-out may well provide all necessary guarantees to those that might be affected by the transaction (ie, minority shareholders and the target's lenders), thus grounding its legality.
(1) One example of this is the United Kingdom, where – before October 1 2008 – the target could provide financial assistance for the acquisition of its own shares or those of a holding company if a whitewash procedure were followed (Section 155 of the Companies Act 1985). This required a director's statutory declaration of solvency, an auditor's report and a special resolution of the company. However, after October 1 2008 the procedure was repealed, with companies thereafter being freely permitted to provide financial assistance in order to acquire their own shares (although the prohibition still applies to public companies and their subsidiaries), or the shares of another private company.
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João Gil Figueira